Will Europe Make Things Worse for Investors?

When European Central Bank President Jean Claude-Trichet announces his decision Thursday on interest rates, investors will be paying far more attention to what he says than what he does.

European Central Bank President Jean-Claude Trichet
European Central Bank President Jean-Claude Trichet

A quarter-point interest rate hike is considered almost a certainty, and few expect that event alone will generate much of a ripple in US markets.

But if Trichet indicates that inflation-fighting, presumably through rate hikes, will become his bank's top priority in the months ahead, it would resonate through US markets and around the world, raising questions about European economic stability and pushing up oil prices further.

"This is an important test for Trichet," says Quincy Krosby, chief investment strategist at The Hartford. "Trichet could very well want to signal to the markets that they're going to fight this inflation and they're going to do it whether or not the economy slows down even more as a result—that they are not going to cave to politicians."

Political ramifications will be an integral part of the equation, as Trichet fights off angry assertions from various European leaders, particularly French President Nicolas Sarkozy, that the euro is grossly overvalued and contributing to the economic slowdown spreading through the continent.

"This isn't Trichet vs. the Fed, this isn't Trichet vs. the talking heads on television. This is Trichet vs. the politicians in the euro zone," Krosby adds. "This is about Trichet's independence and the European Central Banks' independence at an inflection point, which is always the most trying time."

It's a complex battle the ECB president must wage, and how that plays out for the US investor is equally complicated.

A one-off ECB interest rate hike most likely is already priced into the US market and would have little or no effect on the day-before-the-holiday light volume that's expected for Thursday. Anything beyond that, though, would be felt more deeply and likely resonate for days ahead on U.S. markets.

The dollar's weak standing against the euro has amplified the surge in oil costs, and that pattern probably would continue. The broader stock market has invariably declined on days when oil goes up and is likely to continue that pattern until the energy trade falls apart.

Banks also would suffer under further strengthening of the euro, which would widen yield spreads and tighten credit and liquidity. From a trading perspective, that would mean more weakness for a sector that can hardly stand more bad news.

"Anytime you try to predict these things, it's a crapshoot," says Weiss Research currency analyst Jack Crooks, who sees Trichet indicating a one-off rate hike. "If I'm wrong and he comes out tomorrow and says, 'The more we look at this, inflation is such a concern we're going to be aggressive going forward,' then I think you're going to have a big impact on the markets."

Do Central Banks Even Matter?

There are some, though, who wonder whether interest rate changes can even have an appreciable move on stocks any more.

The Federal Reserve Bank has tried in vain to stem the slide in the US economy, but continued inflationary pressures from commodities, particularly grains and oil, have prevented a recovery and weighed on the stock market.

Whether the ECB's monetary policy has equally negligible effects on the US markets will be another dynamic watched closely.

"As oil goes, so go the investors, and I'm not sure it matters all that much who, what or where alters interest rates up, down or sideways," says Diane de Vries Ashley, managing partner of Zenith Capital Partners. "I think the interest rate factors have ceased to have the same impact that they would have under more normal circumstances.

"Without the oil price shocks and inflationary effects stabilizing to some degree, I honestly don't think an interest rate move makes any difference whatsoever."

In fact, de Vries Ashley thinks an ECB rate hike could even provide a psychological boost among investors who would be relieved that at least somebody somewhere is doing something to combat inflation.

"If you get one area of the world that feels itself moderately stabilized and getting some parts of its economic picture under control, you can stop worrying about it," she says.

Likewise, analysts at Schaeffer's Investment Research aren't expecting a major effect from the ECB decision, but for another reason: They think stocks are actually near a bottom, and even terrible news about the euro might serve only as another catalyst for a much-needed stock market capitulation, which marks a level of fear and panic-selling that attracts investors back in.

Ryan Detrick, an analyst with the firm, says the market has been holding its March lows even as it ventures near bear-level percentage drops, something he sees as encouraging.

"We think we're getting pretty close to a potential major bottom. We've noticed a huge influx of extreme negativity," Detrick says. "We think that so much of this negativity is probably very well priced in. The expectations are very, very low for the second half of the year. That's what it could take to have a nice second half."